By Toph Tucker | March 9, 2015
Exchange Traded Funds, or ETFs, are a financial instrument born out of a 1988 840-page SEC Black Monday postmortem. An ETF contains an assortment of securities; you can think of it like a basket tracking an index. For instance, SPY, the world’s most traded security, tracks the S&P 500. Others follow indexes made up of everything from tech stocks to municipal bonds. New ETF shares are created and redeemed by trading the basket for the ETF and vice-versa.
Imagine the stocks below are the ones in the ETF’s basket, sized by the number of shares the stock has. The ETF owns a slice of each.
Now, say you’re a large bank. If you give the ETF a bit of each stock in the basket, the ETF will hold the stock shares and give you a share of the whole fund. The more you do this, the more the fund grows. Try it:
This is good for the fund because it keeps a tiny bit for itself. And it is good for you, the bank; so long as there is demand, you can sell the bits of the basket for more than you paid for the bits of stock.
The values of the stocks in the basket constantly vary, so the value of the basket also varies. But when shares of the basket are trading freely on the market, the price of a share of the basket won’t quite stay in sync with the true value of what it stands for.
This is an opportunity for you, the bank—a balancing act. If the ETF’s price is above its value, you can make money by adding more bits of stock to the fund: Buy the stocks for the cheaper price, sell the ETF for the higher price. You can also do the opposite: If the ETF’s price is below its value, you can return shares of the ETF in exchange for the stocks it stands for, which you can sell for more.
We can imagine the weight of the bits of stock the fund owns balancing atop a fulcrum at the ETF’s market price. They roll to the right as their price goes up, and to the left as their price goes down. Try to keep the price of the ETF balanced near its value by creating and redeeming shares:
The ability to create and redeem shares gives big investors and market makers an incentive to arbitrage the price of the ETF with the fair value of the stocks in the basket. This continuous arbitrage is why an ETF’s price on the exchange is typically very close to the value of the securities in the basket.
So you get paid to get things more balanced; the difference is your prize money. This makes the ETF more useful and reliable to everyone. Congratulations, you’re a market-maker arbitrageur!